Courtesy of: ANTHONY GRAZIANO
I spend a good deal of my professional life forecasting the current value of commercial real estate. The concept is fairly simple; it is the mantra of all valuation; “The value of real estate is represented by the present worth of future benefits.”
In real estate terms, we convert future benefits into economic forecasts. How much income will a property generate annually after all expenses are paid? How long will I hold the asset, and how much income (benefit) will I receive during my holding period? How much will I receive when I sell the asset in the future? These components drive your willingness to pay today.
Invariably, our near-term forecasts tend to be fairly reliable. The problem is, in most commercial real estate investments, the value of the near-term income stream only makes up about 30 percent to 50 percent of the realized return. The balance of the asset’s performance is locked up into the future when you sell the asset, and oftentimes comprises 50 percent to 70 percent of the total return. More than half of the investment’s value is tied to your expectation of the more distant future.
So my firm started looking at our real estate forecasting methods, and those of our professional peers. What we observed is that most appraisers, and a great many investors, hold as their core expectation that the future sale (value) of the asset will grow over time at 3 percent per year.
The problem is that this is not an independent forecast: It is at best an assumption. And our study of longer-term price history over a 25- to 50-year time frame convinces me that the longer you hold an asset, the more likely it is that the 3 percent inflation factor of real estate is woefully low. In many cases, we have revealed property appreciation rates over 20-50 years that approach 15 percent average annual appreciation. Even having bad market timing, and buying at the top of a cycle in 1960, and selling at the bottom of a cycle in 2010 yielded growth rates of 4 percent to 5 percent annually.
To be sure, when you enter the market and when you exit can produce outsize appreciation. Acquiring property in 1970 or 1950 different economic factors were at play. But I can report unequivocally that no one bought a piece of property in 1970 and sold it in 2000 for less money, or for even anything close to only 3 percent annual appreciation of the real estate. In fact, what we’ve found over longer time-series studies is that appreciation rates on acquisitions pre-1980 have average annual appreciation rates greater than 10 percent.
The armchair economists will decry the 1980s as a period of high inflation that artificially spiked these appreciation rates. I agree wholeheartedly: Asset prices were lifted tremendously between 1976 and 1988. These values also crashed spectacularly in 1989 after a national savings and loan bailout and the ensuing Resolution Trust Corp. liquidation of bank real estate assets in the early 1990s.
During the RTC days of 1991-92, analysts were predicting it would take 25 years before asset prices normalized. By 1997-98, asset prices were back to “peak,” and by 2002, people were anxiously awaiting another real estate downturn. It took another six years until 2008 for asset pricing to collapse after massive economic shocks that brought the world economies to the brink of disaster.
We sit here now 10 years later back at “peak” pricing wondering when the next economic shock will send asset pricing down.
I’m here to tell you today: It does not matter. Real estate asset values are fundamental to all economic activity. If your real estate is located in an area with a growing population, it will get more valuable faster, in many cases much faster, than the rate of inflation.
Unlike stocks and bonds, the value of real estate will never go to zero. And if you time the market right, get a little lucky on location, and don’t overleverage so you can ride out periodic downturns, nothing performs better than real estate.
So what if our assumptions on future value are wrong? Then current asset pricing is too conservative, and buying at today’s pricing will provide a much higher return than anticipated.
Will Rogers said it best: “Don’t wait to buy land, buy land and wait.”